Most foreign investors are positive on
Japanese equities and the Nikkei 225 index has increased by more than 100% since
the low of April 2003

By ALI FARID
KHWAJA
Feb 27 - Mar
05, 2006

The Japanese economy finally seems to
be coming out of its economic doldrums. The economic data released on the 17th
of February, showed that the GDP grew at 1.4% in the fourth quarter, taking the
full year growth to 2.8%. The Japanese economy has been in a slump for the last
15 years and even loose monetary policy stimulus by the Bank of Japan in the
form of zero interest rates had not been sufficient to propel a revival. The
recent and ongoing Post Office reforms and restructuring of the financial sector
assisted the turnaround in the economic fortunes. The CPI data released in
November showed a rise of 0.1%, which was a positive signal after the
deflationary pressures had kept inflation at 0% for the last two years. Based on
the upbeat prospects of an economic revival driven by restructuring, most
foreign investors are positive on Japanese equities and the Nikkei 225 index has
increased by more than 100% since the low of April 2003. The growth prospect in
the Japanese economy, along with the unsustainable nature of US economic growth,
leads me to the recommendation that investors should go long on JPY against the
USD.

THE RISE OF YEN:

As I have argued earlier, the Japanese
economic indicators are indicating strong growth. In fact the fourth quarter
growth in Japan exceeded the fourth quarter growth of the 0.3% growth in the US.
Foreign investors have been bullish about the prospects of the economy and most
have increased their weighting of the Japanese equities from 10% to 15%. The
only exception to this has been Morgan Stanley, which recently changed its
weighting to 10% as the Nikkei 225 has increased by 55% in just one year.
However, most analysts tend to be in consensus about the revival of the Japanese
economy, backed by strong structural reforms.

If the CPI data continues to show
further increase, which most observers believe that it would, the Bank of Japan
would have to end its quantitative easing policy and an interest rates' increase
seems near. A change in the interest rates policy would propel the JPY against
the USD and hence I make the case for going long on the JPY. The JPY/USD is
expected to increase to near 0.01.

UNSUSTAINABLE US GROWTH

The US economy needs to attract 70% of
the world's total investment flows to be able to sustain its growing current
account deficit. At present the deficit stands at a record level of 6% of GDP.
The total foreign debt of the US economy has increased to 25% of GDP. With the
recent inversion of the US yield curve the confidence of foreign investors in
the US economy seems to be dwindling. The net foreign inflows in the US economy
last month slowed down to USD45bn as compared to the USD60-80bn required to fund
the current account deficit. The shortfall indicates that the current account
deficit in the US has to adjust, translating into a slowdown in US consumption
(and economy) and depreciation in the exchange rate. Some economists like Regoff
and Obstfeld, believe that a depreciation of around 50% is required to correct
the imbalance. I would further develop on my case on the fragility of the US
economy in later weeks.

CONCLUSION:

In my earlier articles published in
Pakistan and Gulf Economist, I have presented a case for going long in Euro
against the USD. Although over the last three weeks the USD has remained stable,
due to the continuation of tight monetary policy in the US, I still support the
view that the EUR would outperform the USD in 3-6 months. The Euro zone has
shown positive growth over the last three quarters and any positive data would
make the ECB raise interest rates. The Japanese economy presents a similar
though a much stronger case. In the next 6 months, I expect the JPY/USD to rise
to 0.01 as compared to the current levels of 0.00843. The risk to the downside
is the GDP deflator data, which shows that the rise in inflation was mainly due
to pass through of high energy prices. However, if the Japanese economy
continues to grow at these levels, and the consumption growth picks up it would
lead to a change in the monetary policy regime and the JPY would strengthen.
Data releases would be extremely important guide.